Eric Harrington – Free Market, the great American Casino…

In reading about the current financial crisis and the failure of Lehman Brothers, one of the largest financial institutions in the world, I can’t help but wonder, where does all that money that people PAID for the stock go exactly?

I mean obviously, any real assets like ownership in other solvent companies, cash, property etc.., I would assume are liquidated and distributed to stock holders if possible. But as I understand it, as the stock value goes up and down, they don’t actually cash out the ups and downs. It stays in some kind of account that is purely book money. So when the stock price crashes, where exactly does the extra money, above the value of the hard assets go?

I have discovered that in the abstract world of finance, there is a veritable etherspace from which money is created AND later reabsorbed. But unlike energy, it is not preserved. And I have also discovered that money is not real, it is surreal, transient like a rainbow, fading in and out of existence purely based on perception.

Let’s start at the beginning, and discuss how money is created…
The first pervasive form of money was the use of gold. It was permanent, beautiful and desirable. Interestingly, you can actually trace the desirability of gold back to the ancient and surprisingly international concept that “Gold belonged to the Gods”. I will not go into what this really means in its historical context, but suffice to say, gold’s rather magical value has been recognized since the dawn of civilization. While many civilizations used gold coins, the Spanish system known as of pieces of eight, (a clever large gold “coin” effectively perforated into eight pie shaped pieces that could easily be separated with a knife) was a standard in Europe for nearly a century, but coinage was inconsistant, easily counterfeited, and so viewed as unreliable. So around 1600 the first stock market was created in Amsterdam to provide a way of handling investments and trade without the unreliable and easily stolen “coin”, with all transactions taking place purely on paper. But it had no profit potential in and of itself. Only if the person who the money was “invested” made profits then they were shared with the investor. The market was effectively a bank.

For centuries afterward, gold continued to be the basis of currencies throughout the globe including the young United States, and stock markets flourished, but countries soon realized that it was easier to print paper currency, or promissory notes, still backed by gold, meaning you only printed as much currency as you had gold in the treasury, and the note could be “redeemed” for actual gold, presumably if someone wanted to go to another country that would not recognize the US Note. In the early days of currency the Goldsmiths (the first “Banks”) cleverly noticed that over the years on average, they only needed to keep 10% of the money actually on hand for withdrawals. And with this observation, the fractional banking system was born. Fractional banking means that a country will allow a bank to loan out ten-times as much money as they actually have in hard assets.

As the US economy grew and became more complex, the money supply, i.e. the actual money available to facilitate transactions became critical. If there was too little cash available, the prices of the money or “Interest” skyrocketed, and with the advent of the industrial revolution, several super wealthy “robber barons” like JP Morgan had so much money (just prior to the great depression, J.P. Morgan’s net worth exceeded the value of the entire U.S. West of the Mississippi) that they could manipulate the US economies money supply to their advantage. But still, These robber barons immense wealth was entirely based in tangible assets—railroads, buildings, oil wells etc.. In this period, the American Stock market also blossomed from initially selling Government securities literally “on the curb” (hence the AMEX’s original name “The New York Curb Exchange”) to securities or stocks in companies and other entities besides the U. S. Government. Not to get overly simplistic, but stocks are a small piece of the ownership of a company.

But here’s the really tricky part. Regardless of the tangible assets of a Publicly Traded company, i.e. the land, buildings, trademarks, patents, equipment etc.., their stocks value is based completely on perception. The basic principle of the “market” is that value is purely a function of demand. A company with Billions in hard assets, but through some kind of negative market perception becomes an undesirable stock, can have its market value plummet well below the actual value of its assets. Now the “free market” evangelists will tell you that there is always going to be someone out there who recognizes the value of those hard assets of a company and will buy it before it drops that far, but that is only true in normal stable financial conditions. But as we have seen in the recent crashes of 2000 and 2008, markets are increasingly fickle and as greater numbers of unsophisticated investors join the market, the more speculative and perception based, and rife for predatory “crashes” it becomes.

The final nail in the US economic coffin may be the concept of leverage. Leverage allows big investors to buy more stock than they actually have cash to buy. Not so surprisingly, the stock market investments of the small investor are carefully scrutinized to verify that they are being made with cash and not credit. But in the noisy halls of Wall Street it is a different story. Billions are invested everyday effectively on credit, and often with leverage of several times what the investor actually puts up in cash. This Casino action causes the markets to be more and more volatile and subject to bubbles and crashes. Leveraged money globally exceeds 4 times the global GNP. It is estimated that the now infamous derivatives created in the recent mortgage bubble, another form of leveraged investments, exceed 500 TRILLION DOLLARS outstanding. That is 10 TIMES the entire GLOBAL Gross National product. Sound sustainable to you? Me neither..

The “market” today has become more of a Casino, than a system for funding production and creating tangible wealth. It is estimated that nearly half the money “earned” in the US is from money speculation and interest on loans. That means that half of our entire gross national product is “Vapor” and could evaporate with nothing more than bad press. And that is precisely what is happening today. Yes there are bad loans, but the credit crisis is a created crisis. Banks are simply scared and are holding on to money. They have it, they are just guarding it.

So you want to stabilize the US economy? You want to prevent bubbles and crashes? Reduce the volatility and make the market more accurately reflect the growth of the economy as a whole? Simple.. 1) Eliminate Leverage in the stock market. 2) Tax investments so there is a significant incentive for HOLDING stocks, instead of trading. 3) Abolish short selling and other market unfriendly investments. And finally, 4) institute a federal system of regulation of the money and credit supply, not one run and operated by independent international banks i.e. the Federal Reserve. Alan Greenspan could have nipped this bubble when it was a manageable hiccup with a simple increase in the interest rate of 2 points or less. He did not, because bubbles SERVE the rich. They transfer huge sums of wealth from the middle class to the rich. My conservative friends will of course chime in now with “What. You think the big guys don’t get hurt when the market crashes?” and I say absolutely not. When there is a crash they BUY, and all the great economic growth that was paid for by the working classes investments, is bought up for pennies on the dollar, and all the new independent companies created with middle class invention and innovation are consolidated into the great corporate behemoths. NO, they do not! Only the little guy–who cannot buy in a crash because his assets are all but gone– only they lose. Only the pension plans, whose managers are no where near savvy enough to diversify enough, lose. And of course the big companies that just get too greedy like Lehman Brothers. But in the end, it is only the working class, who creates all the TANGIBLE production based wealth of the country, that really lose… The big guys know the difference netween vapor money and hard assets and they win big in hard times.

It is us, the average Americans who lose in this system of bubbles and busts. Just like in your neighborhood casino, a few win and most lose, and increasingly that is becoming the “American Way.” JUST ONE BIG CASINO… And the wise man knows, in the long run only the house wins…

3 Responses to “Eric Harrington – Free Market, the great American Casino…”

Hey man, no picking on your conservative friends now. What a wonderful article. My favorite topic is money. I think there is a Quantum Money theory. Your article is timely, in that we are about to watch the economy spiral clockwise down the drain….

EXCELLENT. So good to find that intelligent people are contemplating the origins of this situation instead of just panicing.

You might enjoy this illustrated fable (a-la-Aesop) that explains the process of hard assets turning into Vapor Money behind the scenes at “The BunniBank”… and how the more intelligent rabbits eventually figured it out (even though the BunniBankers tried to convince them all that they were just “Dumb Bunnies”):